Generally, the IRS requires that you use a specific section of your home "exclusively and regularly" for business purposes to qualify for a tax deduction. That may be a room or even a designated portion of a room reserved for use only by the business.

In addition, the IRS requires that your home must be used:

As your principal place of business;

As a place to meet or deal with clients, patients, or customers in the normal course of your business; or

In any connection with your trade or business where the business portion of your home is a separate structure not attached to your home, such as a shed or garage.

The IRS also offers the option of using a portion of your home for specific types of storage, for rental use, or as a day-care facility. Special rules apply to those situations.

Types of expenses

The IRS uses the terms "direct" and "indirect" to describe home-based business deductions, which are separated into "business expenses" and "capital expenses."

Direct business expenses are costs related solely to the operation of the business, such as a second telephone line you use only for business purposes. The full amount of these expenses is typically deductible.

Capital expenses relate to the purchase of capital assets such as equipment; capital expenses are depreciated by deducting a portion of the cost each year.

Costs related to the use of your home for business purposes are "indirect" expenses. In general, the amount of indirect, home-related expenses that you can deduct is based on the percentage of your home used for business.

So if the portion of the home used exclusively for business purposes is equivalent to 10% of your home's square footage, you can deduct 10% of qualifying indirect expenses.

If you plan to take tax deductions, the enterprise has to be treated as a business, not a hobby.

The IRS forbids deductions based on "unrelated" home expenses. For example, you can deduct a portion of garbage pick-up costs because those services indirectly serve the business. But the cost of painting a room that is not used for the business is an unrelated expense—it cannot be deducted.

The IRS also allows you to take a deduction for depreciation to reflect the wear and tear on your house. The depreciation amount is figured as a percentage of the value of the house, which again is based on the portion of the home used for business purposes.

It's worth noting that you cannot take more home-based deductions than what you make from the home-based business. In other words, you cannot start a home business just to reduce your taxes.

Deduct now, pay more later?

Deducting indirect expenses now may require you to pay additional taxes when you sell your house.

If you claim indirect expenses for your home, the IRS reduces the amount of the capital gains exemption on profits from the sale of your house by the amount of depreciation that could have been claimed on the home itself. This rule is followed even if you never claim a deduction for depreciation.

The only way to avoid this potential issue is to refrain from deducting indirect expenses. In many cases, however, the benefit from annual deductions now outweighs potential taxes on the profits of home sales later.

Do your homework

Stephen Windhaus, founder of business plan consultants Windhaus Associates, Port St. Lucie, Fla., and the author of several business books, says owners of home-based businesses can avoid problems and maximize deductions by planning in advance.

"So many people don't want to plan the business enterprise and then they try to fix the broken links," Windhaus says. "Whether it's paying taxes or deducting business expenses of the home, do your planning, because there may be ways that you can save money."

Business owners who can afford expert help should consult an accountant for advice. If you cannot afford it, Windhaus says you must do extensive research, look for reputable online sites, and consult multiple sources to verify that you are getting accurate information.

Expenses for your car, travel, entertainment, and gifts also may be deductible.

That can help you avoid scams that aim to persuade home-based business owners to buy "kits" or "systems" that claim to maximize deductions but may actually expose you to tax penalties.

Keep track

Whether you're working with an accountant or going it alone, create a system to track expenses. Key elements of this system include sorting and storing receipts and invoices, as well as recording income and expenses on a regular basis.

Tweeten notes that tracking income and expenses provides vital information for business operations. For example, business owners need to know how much to charge to make a profit, how much they must earn in order to pay themselves a fair wage, and how much they must set aside for self-employment or business taxes.

When more than one home-based enterprise exists, Tweeten says it's essential to keep separate records. For example, the owner of a farm who decides to start a second business must handle bookkeeping separately for each business and purchase insurance that appropriately protects the risks of each enterprise.

"If you fail to do this, you can put everything you own at risk," Tweeten notes.

More deductions

Owners of home-based businesses typically qualify for other types of tax deductions. For example, making deposits in an IRA (individual retirement account) can reduce taxes significantly.

Expenses for your car, travel, entertainment, and gifts also may be deductible. Consult the IRS site for rules.

Tweeten notes that business owners who keep good records and follow the rules can seek deductions without fearing undue attention from the IRS.

"Don't be afraid to use your home as the site for your business and then to use the appropriate deductions," Tweeten says. "I've seen people hesitate because they think it's an invitation for the IRS to audit them but, if you've done everything correctly, there's no reason to be afraid."